In an earlier column, I laid out the first three waypoints on our “Road Map to Higher Interest Rates.” Each point involved data related to the economy.
However, we should also focus on the Fed’s actions. Why?
Because every move the bankers make is intentional. And if we watch closely, the Fed will telegraph the timing of the most anticipated hike in interest rates history.
Don’t Flinch Until These Four Events Unfold
I’m convinced that the Fed must do the following things before even considering hiking rates:
~ End the Easing: The Fed has introduced nearly half a dozen “special liquidity facilities” to navigate the financial crisis. So it only makes sense to unwind these facilities before tightening monetary policy.
Fed Chairman Ben Bernanke confirmed last week that the latest round of quantitative easing, known as QE2, will end as planned on June 30. He also squashed speculation about another round of easing (QE3). So go ahead and check off this waypoint on the road map.
~ Sop Up Extra Cash (Temporarily): Before the Fed hikes rates, it needs to drain extra liquidity out of the system. There are two special tools designed to do just that:
Term Deposits: These fixed, short-term deposits (ranging from a few months to a few years) are locked in for the duration of the term and not eligible for early withdrawal without a specific amount of notice. As a result, the interest rates are generally better and it’s considered a safe, low-risk investment.
Reverse Repurchase Agreements: The Fed has bought reverse repurchase agreements (or “repos”) as a way of raising short-term capital. They’re securities that the Fed buys now, with the agreement to sell them for a higher price at a predetermined future date.
The Fed began making reverse repurchase agreements in March 2010, and started auctioning term deposits in May 2010. However, the amounts remain miniscule – to date, approximately $7 billion in reverse repurchase agreements and only $5 billion per auction in term deposits. That’s compared to the $1 trillion in liquidity pumped into the system.
Look for these amounts to increase before the Fed considers increasing rates. In addition, keep in mind that both these tools are temporary fixes, as the cash is ultimately returned.
~ Sop Up Extra Cash (Permanently): The amount of excess reserves in the banking system will require the Fed to remove cash permanently. So expect the Fed to sell some of the estimated $2.8 trillion worth of securities on its balance sheet to accomplish this.
However, the Fed is still buying assets through the end of June. So it’s not even thinking about selling any yet. And most economists don’t expect the Fed to begin selling any assets until early 2012. I agree with them.
~ The Fed Changes its Monetary Policy Statement: Each word in the Fed’s statement is chosen very carefully. And at least a month or two before raising rates, the Fed will need to remove one or two key phrases that have become mainstays throughout the downturn – for example, “exceptionally low” and “extended period.”
However, the Fed’s latest policy statement, released last week, still contained both key phrases.
Buy This Investment Before the Fed Raises Interest Rates
My road map isn’t necessarily sequential. Nor do I think the Fed needs to follow it to the letter before raising interest rates. But the more items we can check off the list, the closer we’ll be to a hike.
Yet even 16 months after I originally created this road map, we can only definitively tick off one waypoint and another two or three partially. That means the waiting game will continue and it will probably be 2012 before the Fed finally gets around to increasing rates.
And before that happens, here’s my tip: Make sure you own this type of bond.